JP Morgan has decided to exercise its right to liquidate the collateral under a $320 million financing arrangement Thornburg defaulted on. This notice of default from JP Morgan triggered cross-defaults with other lenders who can now demand their money back. Unless a white knight emerges, this might be the end of Thornburg Mortgage as we know it.

The contrast with other companies failing due to the sub-prime mortgage mess could not be more ironic. Thornburg is a well respected mortgage lender with high lending standards and one of the lowest default rates in the business.

Thornburg securitizes them or holds them in its own portfolio. To finance the mortgages, Thornburg borrows money from other lenders and pledges its loans and securities based on its loans as collateral. In the past, Thornburg was able to borrow without much difficulty since the collateral was of very high quality. Its business model uses a large amount of leverage, and is dependent on its ability to borrow on a regular basis.

Over the past year, the fall in home prices, and the subsequent rise in the default on loans made to sub-prime borrowers has significantly weakened the secondary market for mortgage loans, and mortgage backed securities. Securities which are not backed by the GSEs

This drop has not only affected the guilty sub-prime segment, but also the prime-Jumbo and the Alt-A (no-doc loans for individuals with a high credit score). This is reflected in the higher rates being paid for Jumbo mortgages at the retail level, where the spread between Jumbo and confirming loans is at one of the highest levels ever. Recognizing this, Congress recently raised the limit for confirming loans which can be purchased by the GSEs to a number determined by the median price of homes in different areas.

This price has little to do with the underlying value of the cash-flow (principal and interest payments) represented by the loans and the securities. It just reflects the pessimism and the lack of liquidity in the secondary market.

Investors are not willing to risk their capital to buy these assets since they are afraid that the price will fall further and mark-to-market rules will force them to book a loss on the value of their holdings. The markets, as they say, are frozen.

If a responsible lender like Thornburg goes under, what is next? If the lenders start liquidating the collateral provided by Thornburg, the price of these securities will fall further.

Mark to market rules will force other investors who own the same or similar securities to write-down their assets. This might lead to new margin calls and another round of forced selling.
Course of Action

Mohamed El-Erian of PIMCO was recently asked this question in an interview on CNBC and his response was that it is time for the Federal Institutions to step in. Market forces have been unable to resolve the problem and the big banks do not have the cash on their balance sheet to step in to be the buyer of last resort. In order to restore the stability of the financial system, the government must act soon.

One of the proposals being considered is for Federal Institutions to purchase mortgage backed securities and provide a bid.

A similar bail-out was arranged after the S&L crisis and the Resolution Trust Corporation turned out to be a good investment by the Federal government (and the tax-payers). A similar effort is needed now to prevent further melt-down in the US credit markets.